The Case for a Strong Dollar

The Case for a Strong Dollar

A popular myth is that the US deficits and recent tax cuts are so huge and out of control that the global investment community will dislike the US economy and sell off their dollar-based assets, making the dollar collapse. Assuming the recent tax cuts aren’t as effective as thought and start to reduce the cuts due to pre-set changes in the law (the whole thing reverts back in less than a decade due to Byrd amendment) then deficits may not get that much bigger. The tax law of December, 2017 actually raised taxes on corporations with offshore operations and closed loopholes such as large personal state income tax deductions, causing some personal form 1040 taxpayers to pay more. The tax law raises taxes on businesses that ship Intellectual Property offshore (the BASE erosion rule), which had been a major source of tax savings for them. Corporations had been in a dynamic trend of shipping IP and subsidiaries offshore to increase their tax savings – now that trend is reversed which means more tax collection.

The problem for dollar bears is that the other countries have much worse economics and need to have a devalued currency. To make a dollar bear thesis work the EU would need to break into a smaller hard money EU in the north and let the southern countries become independent and print and donate to the southern countries some money to pay down some of their debt. Then switch the north to a Thatcherite style economic policy to stimulate it. They will never do that! Also have Japan’s central bank print and gift a pay down of Japan’s government debt. There is a thing called “print and pay” countries, but no such thing as “print and donate”. If the other developed countries were sounder than the US instead of weaker this would make the dollar bear thesis more credible. The fact is the US economy is stronger than any place else and thus in the next recession will need less deficit stimulus and less devaluations than other countries. It will continue to be the least dirtiest shirt in the dirty clothes hamper. Ultimately the fundamental health of the private sector economy is the basis for collecting taxes, which in turn is the basis for a solvent government that can afford to pay back its debt. At least the US can be better able to do that than other countries in order to avoid a growing deficit that spirals out of control.
The markets have occasionally mistakenly believed (when Trichet of EU tightened in 2008!) that EU is a better hard money currency than US but look what happened after GFC in 2008 the EU got into a huge amount of trouble in 2010 and 2012 with far greater contingent risk of an unsolvable debt crisis than the US, and a similar situation occurred in Japan with massive debt and central bank buying of stocks and devaluation. The EU’s ECB truly has maxed out in terms of QE and QE didn’t work for them and they are in deep trouble so I expect that will have no choice in the next recession but do radical, scary things that will scare away capital, making it flee to US. The ripple effect from EU to neighbors such as UK, Switzerland, Norway, etc. will also push investors into the US.
Talk that China will sell our Treasuries is actually not that big of a deal as they only own 5% of them (equivalent to 25% of the Fed’s QE acquisition of bonds, so rather small actually) and the rest of the world needs to buy them. China’s central bank may decide they make a good investment rather than sell simply to punish the US. If China needs to devalue then their holdings of US bonds would produce a windfall profit for their central bank, thus they are unlikely to sell. Some of their holdings may include investment grade ARM MBS yielding almost 5%, far more than can be earned in other developed countries. They have remarked that they prefer to maintain a professional relationship regarding this topic rather than engage in retribution by boycotting Treasuries.
China needs to devalue, which can be done by buying US Treasuries and selling Yuan. When they devalue that will hurt Japan which operates using an exchange rate that is 20% too low based on Purchasing Power Parity (PPP) theory. (Note PPP is not as important as the dynamics of deeply indebted country trying to earn a living to service debts through competitive pricing, thus PPP theory is not applicable when debt loads are excessive). Then Japan will have to redo their devaluation once again, at the same time the EU decides to ramp up QE and deeper negative rates which would act to devalue the Euro.
There are 4 major economic regions: US, EU, Japan, China. The problems with China are dishonest GDP growth figures, massive bad loans held by government owned banks, lack of respect for property rights, rule of law, and freedom to export capital. Problems with EU, Japan well known: excessive debt, slow growth, too addicted to high taxes to be able to cut and stimulate economy, too lacking in respect for entrepreneurial free enterprise thus doomed to have only slow growth, low profit companies. These foreign regions fundamentally are economically weaker and poorer than the US and thus ultimately are less able than US residents and companies to earn income and then pay taxes that could be used to reduce government debt. I am assuming a divided US government stalemate helps trim the deficit and then in January, 2021 a new administration starts to work on raising taxes. The Trump 2016 election was a rare outlier unlikely to be repeated; the establishment is likely to come up with a good response to him while he encounters more difficulties governing, thus in 2020 elections I expect a new regime that may be more traditional and less into huge deficits.
Ultimately other countries have less respect for property rights and reasonable taxes, etc. and thus other countries have a higher probability of caving into parliamentary demands that central banks monetize huge deficits. Yes, the Republican Tea party hard money types vanished when Trump was elected, but there is a strong custom in the US by rural Republicans to pursue tight money policies and once Trump is gone, especially if he is replaced by a weak Democratic president and a divided congress, then the Tea party anti-deficit types may resurface, while they won’t be active in other countries.
The US has its own oil, the other developed countries don’t. Rising oil correlates with rising inflation. Thus if global inflation returns the US will be better able to withstand it. The key to understanding investments and finance is to avoid being overly excited about a corporation’s Balance Sheet including assets, and instead focus on studying the P&L and its contingent outcomes as determined by ability to draw on resources like corporate moats so as to maximize corporate earnings. So first build a firm foundation of a thriving private sector with a good P&L, then build a layer of taxation on the private sector and that is what makes a country have a solvent government and a good currency.
If Congress wants they can impose a national sales tax or a VAT tax like in rest of the world; this is our contingent opportunity to reduce deficits. Other countries already tried this tax and they still ran up too much debt, thus the other countries have shown poor fiscal behavior after maxing out the ability of their citizens to pay taxes; they haven’t fixed deficits. Instead other countries made their deficits worse and now they can’t pay down debt or cut their deficits through they pay more taxes so they are in worse shape than US. The dollar will dominate because we have growth, huge economy, deep broad financial markets, (we are 3x the size of EU financial markets, and have an even bigger difference with Japan markets), free & open markets, and a lack of alternatives to the dollar.

Investors need independent financial advice about the risks of the dollar will appreciate instead of devalue.

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.
Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services.
Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL
PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.